Identifying stocks that are overbought or oversold can be an important part of establishing viable trade entries. Though there are a number of indicators that can be used to assess these conditions, some are more popular than others. Two of the most common indicators of overbought or oversold conditions are the relative strength index (RSI) and the stochastic indicators. Each measurement has its strengths and weaknesses but, like most indicators, they are strongest when used in tandem.
Developed by J. Welles Wilder Jr., the RSI is a measurement of stock price change momentum. RSI is a range-bound oscillator, meaning that it fluctuates between 0 and 100 depending on the underlying security performance, and is calculated based on prior sessions' average gains versus losses. As the number of sessions used in the calculation increases, the measurement becomes more accurate. When the RSI of a given security approaches 100, it is an indication the average gains increasingly exceed the average losses over the established time frame. The higher the RSI, the stronger and more protracted the bullish trend. A long and aggressive downtrend, on the other hand, results in an RSI that progressively moves toward zero.
RSI levels of 80 or above are considered overbought, as this indicates an especially long run of successively higher prices. An RSI level of 30 or below is considered oversold.
The stochastic indicators, like the RSI, are range-bound oscillators. However, where the RSI is calculated based on average gains and losses, stochastics compare the current price level to its range over a given period of time. Stocks tend to close near their highs in an uptrend and near lows in a downtrend. Therefore, price action that moves further from these extremes toward the middle of the range is interpreted as an exhaustion of trend momentum.
A stochastic value of 100 means that the current session closed at the highest price within the established time frame. A stochastic value of 80 or above is considered an indication of an overbought status, with values of 20 or lower indicating an oversold status.
Both the relative strength index and stochastics have strengths and weaknesses. Like most technical indicators, they are strongest when used in tandem and in combination with other tools designed to establish optimal trade entry points.